Pure Competition

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Market structure – identifies how a market
is made up in terms of:
The number of firms in the industry
The nature of the product produced
The degree of monopoly power each firm has
The degree to which the firm can influence price
Profit levels
Firms’ behaviour – pricing strategies, non-price
competition, output levels
The extent of barriers to entry
The impact on efficiency

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Economists group industries into four distinct
market structures based on their
characteristics. The four market models are:
Pure competition
Monopolistic competition
Oligopoly
Pure monopoly

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Pure competition is one of four market
structures in which thousands of firms each
produce a tiny fraction of market supply in their
respective industries.
Examples: farm commodities (wheat, soybean,
strawberries, milo), the stock market, and the
foreign exchange market

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Very large numbers – a large number of
independently acting sellers who offer their
products in large markets.
Standardized product – firms produce a
product that is identical or homogenous.
Price taker – the firm cannot change the
market price, but can only accept it as
“given” and adjust to it.
Free entry and exit – no barriers to entry
exist.

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Advantages:
optimal allocation of resources
competition encourages efficiency
consumers charged a lower price
responsive to consumer wishes: Change in demand, leads extra
supply 
Disadvantages:
insufficient profits for investment
lack of product variety
lack of competition over product design and specification
unequal distribution of goods & income
externalities e.g. Pollution

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The demand schedule and demand curve faced
by the individual firm in a purely competitive
industry is perfectly elastic at the market price.
Recall that the firm is a price taker and cannot
influence the market price.
However, the industry as a whole, which determines
the market demand curve, can affect price by
changing industry output.

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INDUSTRY (OR
MARKET) DEMAND
AND SUPPLY
INDIVIDUAL
FIRM DEMAND
Price
P
Q
Quantity Quantity
Price
S
D
D

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MARKET DEMAND AND SUPPLY FIRM DEMAND
Price
P
1
Q
1
Q
2 Quantity Quantity
Price
S
1
D
D
1
S
2
If market supply increases, the market price falls. Since each firm is
a price taker, it has no choice but to charge the lower price for its product.
P
2 D
2

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Average revenue (AR) is total revenue from
the sale of a product divided by the quantity of
the product sold.
AR = TR ÷ Q
Total revenue (TR) is the total number of
dollars received by a firm from the sale of a
product.
TR = P x Q

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Marginal revenue (MR) is the change in
total revenue that results from selling 1 more
unit of output.
MR = (change in TR) ÷ (change in Q)
MR is constant at the market determined price—
each additional unit of output produced adds the
same amount to total revenue.

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Graphically, total revenue is a straight line that
slopes upward to the right.
The demand, marginal revenue, and average
revenue curves are horizontal at the market
price P. All three curves coincide.

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TR
D = AR = MR$4
Price
Quantity
1234
$8
$12

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Because the purely competitive firm is a price
taker, it can maximize its economic profit (or
minimize its economic loss) only by adjusting
its output.
In the short run, the firm can adjust its variable
resources (but not its fixed resources) to
achieve the output level that maximizes profit.

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In deciding how much to produce, the firm will
compare the marginal revenue and marginal
cost of each successive unit of output.

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As long as producing is preferable to shutting
down, the firm should produce any unit of
output whose marginal revenue exceeds its
marginal cost.
If the marginal cost of a unit of output exceeds
its marginal revenue, the firm should not
produce that unit.

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A method of determining the total output at
which economic profit is at a maximum (or
losses at a minimum) is known as the MR
= MC rule.
This rule only applies if producing is preferable to
shutting down.
In pure competition only, we can restate this rule
as P = MC.
A firm will adjust output until marginal revenue is
equal to marginal cost.

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Profit Maximization
If price exceeds ATC at the MR = MC output
(q*), the firm will realize an economic profit
equal to q*(P – ATC).
Loss Minimization
If price exceeds the minimum AVC but is less
than ATC, the MR = MC output will permit the
firm to minimize losses equal to q*(P – ATC).

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MC
MR
P
Q
ATC
AVC
P*
ATC
q*
ECONOMIC
PROFIT
Using the MR = MC rule, output is q*. Since price is greater
than ATC at q*, the firm is earning an economic profit.

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The price is less than ATC at q* so the firm is making a loss.
Since price is greater than the minimum AVC at q*, the firm
continues
to operate
at a loss.
MC
MR
P
Q
ATC
AVC
P*
ATC
q*
AVC
LOSS

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Shutdown
If price falls below the minimum AVC, the
competitive firm will minimize its losses in the
short run by shutting down.
A firm shuts down if the total revenue that it
would get from producing is less than the
variable costs of production.

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P
1
P
2
P
4
P
3
Break-even
(normal profit)
point
Shutdown point
(if P is below)
MC
quantity
ATC
AVC
Price
MR
1
MR
2
MR
3
MR
4
MR
5
P
5
Q
2
Q
3
Q
4
Q
5

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Generalized Depiction
Price P
1
is below the firm’s minimum AVC; the firm
will not operation and quantity supplied will be zero.
Price P
2
is just equal to the minimum AVC. The firm
will produce at a loss equal to its fixed cost.
Between price P
2
and P
4
, the firm will minimize its
losses by producing and supplying the MR = MC
quantity.

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Generalized Depiction
At price P
4
, the firm will just break even and earns a
normal profit.
At price P
5
, the firm will realize an economic profit
by producing to the point where MR (=P) =
MC.

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The competitive firm’s short-run supply
curve tells us the amount of output the firm
will supply at each price in a series of prices.
It is the portion of the MC curve above the
shutdown point.
It slopes upward because of the law of diminishing
returns.

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Equilibrium price is determined by the
intersection of total, or market, supply and total
demand.
The individual supply curve of each of the identical
firms in an industry are summed horizontally to get
the total supply curve.
The market supply together with market demand
will determine the equilibrium price in a competitive
industry.

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The long-run assumptions in a competitive
industry are:
The only adjustment is the entry or exit of firms.
All firms in the industry have identical cost curves.
The industry is a constant cost industry.